A cap rate — capitalization rate — is a property's net operating income divided by its price, expressed as a percentage. It's the market's shorthand for pricing income, and it works in both directions: divide NOI by a cap rate and you get value. A property earning $1,150,000 at a 5.75% cap rate is worth $20 million.
Why Cap Rates Matter in CRE
Cap rates compress (fall) when investors will pay more per dollar of income — cheaper debt, stronger rent-growth expectations, durable tenancy, deep buyer pools — and expand (rise) when money gets expensive or the income gets riskier. Because value equals NOI divided by the cap rate, small moves carry outsized weight: the denominator is a small number, so a quarter-point shift can reprice an asset by several percent.
That leverage on value is why the cap rate assumption draws more scrutiny in investment committee than almost any other input in the model.
A Worked Example
Take a property producing $1,150,000 of NOI and price it at two cap rates half a point apart:
- NOI: $1,150,000
- Value at a 5.5% cap: $1,150,000 ÷ 0.055 ≈ $20.9M
- Value at a 6.0% cap: $1,150,000 ÷ 0.060 ≈ $19.2M
- Gap: ≈ $1.7M — about 8% of value
Half a point — the kind of move a market can make in a couple of quarters — is worth about $1.7 million on this asset. The building and its income didn't change; the market's pricing of income did. That's why disciplined underwriting shows value across a range of cap rates instead of betting the returns on one.
Entry Caps, Exit Caps, and When the Number Misleads
The entry cap is today's NOI over today's price. The exit cap is the rate you assume a future buyer applies at sale — and most disciplined models set it above the entry cap, often by 25–50 basis points, as a hedge against an aging asset and market drift. An underwriting that needs exit-cap compression to hit its return target deserves a hard look.
Cap rates also mislead when in-place NOI isn't the real story. A value-add deal with below-market rents might show a 4.8% cap on current income but a 6.2% cap on stabilized income — the low headline isn't rich pricing, it's unrealized income. Before trusting any cap rate, ask which NOI it's sitting on.
How Teams Handle Cap Rates Today
Mostly as a sensitivity table in each deal's spreadsheet, rebuilt by hand whenever NOI or the debt quote moves. With Playgrounds, you describe the model and get an underwriting app with live value sensitivity across entry and exit cap rates — recalculated as the deal's numbers change.
Frequently Asked Questions
What does a lower cap rate mean?
Buyers are paying more per dollar of income — usually a sign of lower perceived risk, stronger growth expectations, or heavy competition for that asset type. A 4.5% cap deal is priced richer than a 6.5% one, not earning more.
What is a good cap rate?
There's no universal number — cap rates vary by asset type, market, and asset quality, and they move with interest rates over time. The useful question is whether a deal's cap rate is appropriate relative to comparable recent sales and to the cost of debt.
What's the difference between entry and exit cap rate?
The entry cap prices the deal today: in-place NOI over purchase price. The exit cap is an assumption about how a future buyer will price the income at sale. Most models assume a modestly higher exit cap as a conservative default.
Why can cap rates be misleading?
Because the headline rate depends on which NOI it's calculated from. Below-market rents, expiring concessions, or one-time expenses can make a fairly priced deal look expensive — or an expensive one look cheap. Verify the NOI before trusting the cap rate.
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